The Political Economy of Capitalism - Harvard Business School

1 07-037 Copyright 2006 by Bruce R. Scott Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. The Political Economy of Capitalism Bruce R. Scott #07-037 Abstract Capitalism is often defined as an economic system where private actors are allowed to own and control the use of property in accord with their own interests, and where the invisible hand of the pricing mechanism coordinates supply and demand in markets in a way that is automatically in the best interests of society. Government, in this perspective, is often described as responsible for peace, justice, and tolerable taxes. This paper defines Capitalism as a system of indirect governance for economic relationships, where all markets exist within institutional frameworks that are provided by Political authorities, governments.

2 In this second perspective Capitalism is a three level system much like any organized sports. Markets occupy the first level, where the competition takes place; the institutional foundations that underpin those markets are the second; and the Political authority that administers the system is the third. While markets do indeed coordinate supply and demand with the help of the invisible hand in a short term, quasi-static perspective, government coordinates the modernization of market frameworks in accord with changing circumstances, including changing perceptions of societal costs and benefits. In this broader perspective government has two distinct roles, one to administer the existing institutional frameworks, including the provision of infrastructure and the administration of laws and regulations, and the second to mobilize Political power to bring about modernization of those frameworks as circumstances and/or societal priorities change.

3 Thus, for a capitalist system to evolve in an effective developmental sense through time, it must have two hands and not one: an invisible hand that is implicit in the pricing mechanism and a visible hand that is explicitly managed by government through a legislature and a bureaucracy. Inevitably the visible hand has a strategy, no matter how implicit, short sighted or incoherent that strategy may be. 1 The Political Economy of Capitalism1 Microeconomics is the study of how markets the usual defining institution of Capitalism coordinate decentralized decision making through a price mechanism to bring supply and demand into equilibrium. In this time-tested perspective, Capitalism is a largely self-regulating economic system in which the proper role of government is limited to providing certain basic public goods and services at low cost.

4 Harvard Professor Gregory Mankiw, the author of a leading economics textbook and former Chairman of the President s Council of Economic Advisors, recently reminded readers of the Wall Street Journal of this point of view, claiming: Adam Smith was right when he said that Little else is required to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes and a tolerable administration of justice. 2 Smith s explanation for this minimalist role for government was derived from his seminal insight that the pricing mechanism would coordinate the actions of private actors so as to achieve socially optimal outcomes. Or, in Smith s words: As every employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of greatest value; every individual labours to render the annual revenue of society as great as he can.

5 [While] he intends only his own gain, ..he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. 3 However, if market prices are to coordinate the actions of economic actors so that they spontaneously maximize the revenues for society as well as for individuals, then those market prices must reflect true societal costs and benefits. While markets may well reflect such costs and benefits, there are certain well known situations where they fail to do so. Externalities, where certain costs and benefits are not fully included in the market framework, are the most immediate exception to Smith s assumption. Externalities reflect imperfections in the laws and regulations that make up the market frameworks. These imperfections cannot legitimately be corrected by the economic actors themselves; the corrections must be made by a Political authority, , government.

6 Furthermore, any framework must be modernized periodically in light of changing conditions and changing societal priorities, and this again requires government. Unless the market frameworks are appropriately adjusted, including as circumstances change, then there can be no assurance that the maximization of individual incomes approximates a similar outcome for society. To say that little is required from government but peace, easy taxes and tolerable administration is to overlook the essential role of government in providing the legal and regulatory frameworks that are essential to Capitalism . It reduces the study of Capitalism to the analysis of 1 Bruce R. Scott, Chapter 2, Capitalism , Democracy and Development, June 27, 2006. 2 Adam Smith, as favorably cited by Gregory Mankiw, The Wall Street Journal, January 3, 2006.

7 3 Adam Smith, Wealth of Nations, Oxford world Classics, pages 291-292. 2how markets operate in a static context that has assumed away the regulatory and Political issues. This chapter aims to introduce the Political Economy of Capitalism in order to take note of two modes of governmental intervention, direct and indirect, and to highlight two differing roles of government, administrative and entrepreneurial. The chapter begins with an austere definition of Capitalism which calls attention to the idea that Capitalism is a socio- Political system as well as one that is economic. I will enhance this definition to include the notion that Capitalism is an indirect system of governing an Economy wherein various economic actors are allowed to compete to serve the needs of consumers according to a set of laws and rules, and where the ensuing competition serves to induce the mobilization of human energy and talent as well as other resources for the benefit of society as well as the economic actors themselves.

8 Organized sports provide a useful analogy through which to gain insights on Capitalism . Organized sports may be seen as having a three-level system of governance, through which a Political authority delegates the rules and regulations that structure the game itself. A capitalist society can be broken down into a similar structure, in which a Political authority mobilizes resources to provide and administer the infrastructure that facilitates and structures economic activity. Finally, firms, like sports teams, compete within this structure. After presenting a three level model of Capitalism I will look in more detail at each of these levels to identify some of the key organs of a capitalist system. In order to illustrate the Political and administrative roles of government in a capitalist system, I present three metaphoric market frameworks to show how they can be shaped or tilted for reasons of policy.

9 I flesh out these ideas with two examples of product markets that have been shaped for policy reasons, and then an example from the factor markets (for labor). In conclusion, I suggest that government plays an active and essential role in a well-functioning capitalist Economy , and not one that is either passive or peripheral. What is Capitalism ? Capitalism is a system of governance for economic affairs that has emerged in different settings and continues to evolve over time. As a consequence it evades simple definition. The Macmillan Dictionary of Modern Economics defines Capitalism as a: Political , social, and economic system in which property, including capital assets, is owned and controlled for the most part by private persons. Capitalism contrasts with an earlier economic system, feudalism, in that it is 3characterized by the purchase of labor for money wages as opposed to the direct labor obtained through custom, duty or command in Under Capitalism , the price mechanism is used as a signaling system which allocates resources between uses.

10 The extent to which the price mechanism is used, the degree of competitiveness in markets, and the level of government intervention distinguish exact forms of This austere definition identifies Capitalism as a social, Political , and economic system that succeeded feudalism based upon recognition of the rights of private parties to choose how to employ their labor and capital in markets as indicated by market prices instead of tradition. It recognizes the price mechanism as its key coordinating device instead of command and control, and suggests that capitalist systems are distinguishable from one another based upon the extent and nature of governmental interventions and the competitiveness of their markets. However, this definition offers only a very brief introduction to the notion of Capitalism as a system. It does not, for example, distinguish between direct and indirect modes of governmental intervention nor its administrative and entrepreneurial roles.